Technical Analysis

What it is:

Technical analysis is a methodology that makes buy and sell decisions using market statistics. It primarily involves studying charts showing the trading history and statistics for whatever security is being analyzed.

How it works (Example):

To perform technical analysis, investors start with charts that show the price and trading volume history of a particular security or index (for example, the Dow Jones Industrial Average) as well as host of other statistical measures such as moving averages, maximums and minimums, and percentage changes.

The idea is to use the charts to identify trends and changes in those trends. There are several kinds of trends and patterns, some with unusual names: rectangles, triangles, Bollinger bands, inverted heads and shoulders, candlesticks, the MACDhistogram, stochastics, and so forth. Some technical analysts also use indicators and oscillators to interpret trading data.

Why it Matters:

Unlike fundamental analysis -- which focuses on finding a security's "true value" by studying financial statements, market outlooks, competition, macroeconomic events, etc. -- technical analysis is based on the belief that past market trends can predict the future behavior for the market as a whole and for individual stocks.

If an investor can correctly interpret a chart's "message" and predict a stock's movement, he or she can obviously make a lot of money. Certain aspects of technical analysis are controversial, such as the belief that stocks and markets move in trends that can play out over a long period of time, and the contention that market action can detect shifts in supply/demand relationships.

Most investors tend to be either technicians or fundamental investors, though many analysts believe that combining technical and fundamental analysis is the best way to evaluate exit and entry points. Since many people believe in technical trading rules, at the very least the rules can become self-fulfilling, making them important to know for the individual investor.

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